There is ample evidence that some investors are inattentive and cause stock prices to fluctuate in ways that disagree with the rational framework. However, a less studied question in the behavioral finance literature is how firm managers respond to fluctuations in stock prices that stem from such irrational trading behaviors. In our recent paper, we exploit a novel change in the information environment of firms that allows us to explore how investor inattention impacts corporate decisions.
The accounting rule that we study is Accounting Standards Update (ASU) 2016-01, which was announced by the Financial Accounting Standards Board (FASB) in 2016 and became effective for fiscal years starting after Dec 15, 2017. It requires publicly traded companies to incorporate changes in unrealized gains and losses (UGL) from public stock investments into net income. Prior to the rule change, firms that invest in public stocks already reported such changes in unrealized gains and losses in financial statements. This means that ASU 2016-01 only changes the way in which financial performance information is presented to investors, and not the quantity and quality of such information.
If investors are fully rational and perfectly attentive, then this accounting rule change should not have any effect on their trading decisions and, thus, stock prices. However, if investors are inattentive and only focus on summary measures, such as net income, then investors may treat these fluctuations in net income as meaningful changes in the companies’ prospects and therefore trade on this information. Since managers care about their companies’ stock prices (e.g., their compensation packages are often tied to their companies’ stock prices), inattentive investors’ irrational trading behaviors may also affect firms’ decisions to invest in public stocks.
We formalize the economic intuition above by building a model where investors are either attentive or inattentive, and managers are fully rational. Investors are risk averse and trade to maximize expected utility, while managers maximize their firms’ stock price by choosing the optimal level of investment in financial assets. Firms have two streams of earnings: operating income and financial income. Operating income is more persistent because it comes from the firm’s core business. Financial income is less persistent because it comes from changes in the market value of the firms’ financial assets (investments such as stocks and bonds). Attentive investors can process and understand the two streams of earnings and how they differentially impact firm value. On the other hand, inattentive investors cannot distinguish between the two earnings components, and instead value the firm based on net income alone.
The model’s first prediction is that, when financial income is included in net income, firms’ stock prices react to fluctuations in net income that stem from changes in the value of the firm’s investments. This result is driven by inattentive investors’ inability to distinguish between operating and financial income earnings streams. The model’s second prediction is that, since the inclusion of financial income makes net income more volatile and potentially less informative about the value of the core business, inattentive investors perceive the firm’s earning stream to be riskier and therefore apply larger discounts to stock prices. This effect is stronger when financial income is more transitory or measured more accurately relative to core operating income. In response, managers will likely reduce their firms’ investment in financial assets. This result has direct implications for the accounting of marketable securities like stocks, since their fair value changes tend to be transitory and their measurement tends to be accurate. Including them in net income may cause this measure to be less useful for inattentive investors and affect firms’ optimal investment behavior.
We test these predictions using hand-collected insurance company data. We begin by showing that, after the new rule was implemented, insurers’ earnings volatility increased and earnings persistence decreased. Next, we apply the event study approach to earnings announcement dates to show that risk-adjusted stock returns do not respond to changes in unrealized gains and losses from public stock investments in the period before the new rule but do so in the period after. Such subsequent return reactions are economically large and persist up to 60 trading days. These results support the idea that inattentive investors only pay attention to changes in UGL on equity securities to the extent such changes drive variation in net income.
Since earnings announcements occur after the quarter-end date and stock returns react predictably to changes in UGL on equity securities, we devise a trading strategy that exploits how the stock market performed in the prior quarter. When the Center for Research in Security Prices (CRSP) value-weighted stock index return is positive in the prior quarter, we go long insurance company stocks in anticipation of positive return reactions around the upcoming earnings announcements. When the CRSP value-weighted stock index return is negative in the prior quarter, we sell short insurance company stocks in anticipation of negative return reactions around the upcoming earnings announcements. Before ASU 2016-01 was implemented, this trading strategy did not yield a positive and statistically significant average return. However, in the period after the rule change occurred, the 12-day average return of this trading strategy is 2.5% and is statistically different from zero.
To give additional evidence that investor inattention is driving the return reaction results, we compare insurers with many sell-side equity analysts following them to those with few. Investors face information processing costs and sell-side equity analysts lower this cost by presenting synthesized versions of companies’ financial statements that more cleanly capture the companies’ current and future performances. With respect to ASU 2016-01, anecdotally, analysts exclude changes in equity UGL from their earnings forecasts, which allows investors to more easily learn about companies’ core performance. Therefore, if inattentive investors read analyst reports, they are less likely to overreact to changes in equity UGL. We find that this is indeed the case. Return reactions are relatively muted among insurers that have above-median analyst coverage.
Lastly, we use the difference-in-differences approach to test our model’s prediction that the new rule causes firms to decrease investments in financial assets. Since private insurers were not subject to the new rule, we compare how public insurers change their equity allocation relative to private insurers after the rule change. We find that, after ASU 2016-01 was implemented, insurance subsidiaries of publicly traded companies decreased their allocation to public stocks by 0.47 percentage points, relative to private insurers. A back-of-the-envelope calculation shows that, by 2020, insurance subsidiaries of publicly traded companies reduced their holdings of public stocks by approximately $23 billion, which is equivalent to approximately half of their aggregate public stock holdings.
In summary, this paper shows that inattentive investors’ influence on stock prices induces managers to buy less publicly traded stocks. For the insurance industry, this result has several important implications. First, lower equity allocations could potentially lead to lower long-run investment returns. Ultimately, lower returns impair insurance companies’ ability to underwrite new policies, meet upcoming claims, and help individuals share risks. Second, since exchange-traded funds (ETFs) are generally classified as equity securities under US generally accepted accounting principles (GAAP), ASU 2016-01 may have discouraged insurance companies from buying instruments such as bond ETFs, thereby slowing the growth of the ETF industry.
With respect to setting accounting standards, our paper helps inform the debate over the merits of ASU 2016-01. FASB implemented the rule change based on the belief that changes in unrealized gains and losses on equity securities reflect meaningful changes in the companies’ underlying economic conditions because companies can realize these gains and losses immediately by liquidating their equity positions. On the other hand, investors, such as Warren Buffett, and sell-side analysts believe that this change would make net income numbers less informative. Our paper provides supporting evidence for the latter view by showing that investors overreact to changes in unrealized gains and losses, which implies that investors are potentially confused by the new net income numbers.
Natee Amornsiripanitch is a Research Economist at the Federal Reserve Bank of Philadelphia
Zeqiong Huang is an Assistant Professor at the Yale School of Management
David Kwon is a PhD Candidate at the Yale School of Management
Jinjie Lin is a PhD Candidate at the Yale School of Management
This post is adapted from their paper, “Net Income Measurement, Investor Inattention, and Firm Decisions” available on SSRN.